How do lenders structure a line of credit for a general contractor or remodeler?

A general contractor's cash is mostly other people's money

A commercial general contractor bills the owner for the whole job, then pays the subcontractors and suppliers who did most of it. Receivables and payables are both large, and the contractor's own margin is the narrow difference between them. A lender that looked only at the receivables line would badly overstate what the contractor can repay; the question is what is left after the subcontractors are paid.

Three features of construction payment decide how that works in practice:

• Pay applications. The contractor bills monthly against a schedule of values. The owner's architect and, on financed projects, the owner's construction lender and its inspector must approve each one before the owner's lender funds the draw.
• Lien waivers and lien rights. Subcontractors and suppliers can lien the owner's property if they go unpaid, so owners require conditional and unconditional waivers with each draw. A general contractor that falls behind paying its subcontractors soon finds its own receivables held up.
• Trust fund statutes. Several states treat money a contractor receives for a project as held in trust for the subcontractors and suppliers on that project. Diverting it — including to pay down a bank line — can create personal liability for the owners, and lenders structuring a sweep of contract proceeds have to respect it.

The result is that a general contractor's real working capital need is smaller than its revenue suggests but more sensitive to timing. It peaks when an owner pays late while subcontractors, protected by their lien rights, still expect to be paid, and when a pay-when-paid clause fails to hold up.

Commercial general contractors and residential remodelers are different borrowers

Lenders put both under "construction", but the files read nothing alike.

A company that does both — a commercial builder with a residential division, or a remodeler moving into light commercial work — should present them separately. Blending a project receivable book with homeowner deposits makes both look worse than they are.

Overbillings: the line of credit the contractor already has

On a percentage-of-completion work-in-progress schedule, an overbilling is revenue billed ahead of the work performed. General contractors create them deliberately, by weighting the schedule of values toward early line items such as mobilization and general conditions. The cash comes in before the cost does, and for a growing contractor overbillings quietly fund operations.

The trouble comes when backlog stops growing. As jobs finish, the overbillings unwind: the contractor has to spend the cash it collected early, and new jobs are not refilling the pool. This is the point at which a contractor runs out of other people's money, and it is where many general contractors first reach for their line.

Nothing in that table is a loss. The contractor may be profitable in all three years. But the line has gone from unused to heavily drawn as the billing position turned, and a lender that read only the P&L would miss why. This is why banks read the WIP schedule every quarter and track the net of overbillings and underbillings over time, and why a line sized in a growth year can be too small two years later. The general method is on sizing a working capital line.

Overbillings are a liability, not a cushion. Cash collected ahead of the work is owed back to the job, and a lender will not count it as the contractor's own.

What a borrowing base counts for a general contractor

Larger general contractors can get an asset-based line, and the same eligibility rules apply as elsewhere, with construction-specific cuts. Asset-based lenders typically advance 80% to 90% of eligible receivables, but on a general contractor the eligible pool is narrow:

• Only approved pay applications count; billings still under the architect's review do not.
• Retainage is ineligible until closeout, and invoices more than 90 days past billing are ineligible.
• Receivables on bonded jobs are often excluded because the surety has rights to contract proceeds in a default.
• Amounts the contractor owes the same owner, or back-charges the owner has claimed, are netted out as contras.
• A single owner or developer is commonly capped at 20% to 25% of eligible receivables, and many general contractors have one or two dominant clients.
• Some lenders also reserve for subcontractor payables that relate to the billed work, since unpaid subcontractors can stop the owner from paying.

Because so much falls out, many banks lend to mid-sized general contractors on a cash-flow line instead, sized on earnings, working capital and net worth, and supported by personal guarantees. The trade-offs between the two approaches are on asset-based versus cash-flow lines.

Remodelers: deposits, draws and the homeowner

A residential remodeler usually collects a deposit when the contract is signed, draws at milestones such as demolition, rough-in and cabinets, and a final payment when the punch list is done. Handled well, the remodeler is paid ahead of its costs for most of a job and needs little working capital. Several states limit how large a home-improvement deposit can be, which shortens that cushion.

Lenders look at two things. First, whether deposits are being spent on the job they came from. A remodeler that uses new deposits to finish old jobs looks healthy while sales grow and fails quickly when they slow; a lender tests it by comparing deposits held against the cost still to be incurred on open jobs. Second, the true needs a line should fund: cabinets, windows and specialty materials ordered weeks before installation, a winter slowdown in colder markets, and gaps when a homeowner's financing draws slowly.

Because homeowners are consumer obligors, many asset-based lenders will not count remodeling receivables at all. Remodeler lines are therefore usually modest cash-flow lines from banks, sized on historical earnings and backed by the owners' guarantees, often with an annual clean-up period. Builders that construct homes or buildings for sale, rather than for a client, can look at the SBA's builder line, covered on SBA CAPLines.

Covenants, guarantees and reporting

Bank lines to general contractors typically carry a minimum working capital or current ratio, a minimum tangible net worth, a maximum debt-to-worth ratio, and a debt service coverage test, where conventional bank lenders commonly look for at least 1.25x. Reporting includes the quarterly WIP schedule, the AR and AP agings, and annual statements reviewed or audited by a CPA who knows construction accounting — which the surety usually requires anyway.

Owners should expect to guarantee the line personally, and on a secured line the bank takes a blanket lien on business assets. Contractors with bonding programs need the bank and surety to agree on priorities over contract receivables before the line closes, not after a problem job.

What trips general contractors up

• Profit fade. Estimates that assumed too little cost show up as shrinking gross profit late in the job, when there is no billing left to cover it.
• A subcontractor default. The general contractor must finish the work, often by paying a replacement at a premium, and cannot bill the owner twice.
• Pay-when-paid that does not hold. Courts in many states read these clauses narrowly, so the contractor may owe its subcontractors even when the owner has not paid.
• Distributing overbillings. Cash from early billings looks like profit in the bank account. Taking it out leaves nothing to finish the jobs.
• Stopgap financing. Merchant cash advances used to bridge a slow draw make the next draw harder; see refinancing cash advances for contractors.

Preparing the file

Transparent's line-of-credit checklist covers the core: the AR aging by customer with days outstanding, the AP aging, balance sheet, P&L and a year-to-date P&L, a debt schedule showing existing liens, and optionally bank statements and two to three years of business tax returns. A general contractor should add the WIP schedule reconciled to the balance sheet; a remodeler should add a schedule of open jobs showing deposits held and cost to complete.

Transparent's book holds 235 lenders that write asset-based loans and lines, among 1,800+ lenders in all, and they differ sharply in appetite for construction. Transparent builds the full lender package — financing model, lender presentation, blind teaser and underwriting memo — in a day once documents are in, with the billing position explained up front rather than discovered in diligence. Remodelers thinking about buying rather than borrowing should see financing a remodeling company acquisition; trade contractors will find their own lines on electrical contractors and roofing contractors.